Mastering Illiquidity: Risk management for portfolios of limited partnership funds

15

Securitization

Securitizations of portfolios of illiquid assets make use of the general techniques widely known in the context of collateralized debt obligations (CDOs) or collateralized fund obligations (CFOs) (Fabozzi and Kothari, 2008). As discussed in previous chapters of this book, risk management for illiquid asset classes has to address the non-tradability and lack of a continuous price discovery. One of the main ideas of securitization is the transformation of a pool of illiquid assets into various tranches for tradable notes with different risk and return characteristics. These notes can be quoted on exchanges and, hence, traded. Through “layering” the pool of assets into tranches, the risk is also transferred into different notes. Each different note has more standardized risk characteristics, thus investors feel more comfortable valuing it and trading such notes.

Securitizations of portfolios of limited partnership funds establish a link between the default risk element (similar to a bond) and market risk (similar to equity). In this chapter, we demonstrate how, even for such illiquid assets, one risk dimension can be transformed into another and trade-offs between risk dimensions can be managed: e.g., equity into debt, market into credit risk, illiquidity into liquidity, liquidity risk into capital risk. While the structural elements of the transactions are very similar, the modelling and understanding of the different illiquid asset classes are different, creating ...